The Investment Scientist

Is This The End of the Small Cap Value Premium?

Posted on: March 28, 2021

My long-term readers will remember that since I started writing investment missives, I have always advocated small-cap value investing. That is, holding a broadly diversified portfolio but with a weighting tilt towards small-cap value stocks. 

Up until 2014, the historical evidence is overwhelming. Literally, since there have been stock market data, looking at rolling ten-year periods (see chart below,) there have been only two ten-year periods when small-cap value stocks under-performed large-cap growth stocks, ending in 1998 and 1999 respectively. These ten-year periods corresponded to the dot-com tech-stock bubble in the US.

In fact, as recently as 2009, the ten-year prior outperformance was 12.9% per year! But since then, the outperformance has been dwindling and in 2014 it finally turned negative. By the end of 2020, small-cap value stocks had a massive underperformance of 7.9% per year during the prior ten-year period!

I believe there has been a certain structural change in the economy that tilted the advantage to some large-cap growth stocks. That is, the emergence of platform companies that don’t just provide products or services, but provide platforms on which social and economic activities happen. 

What are the differences between products/services and platforms? A company with a great product or service can still be easily usurped by a better product or service or a new technology  GE comes to mind. A company that owns a popular platform, however, can be very hard to usurp, thereby enabling it to earn exorbitant profits. Even if someone were to create a better social network app than Facebook, nobody would go because all their social networks are on Facebook. (This paragraph is not stock picking advice, but simply an illustration.)

However as reasonable as my observations are, I must also guard against the recency bias. That is, we humans tend to draw our lessons from our most recent experiences, ignoring all prior evidence. So while I am seeking more exposure to platform companies, I am not abandoning small-cap value investing. 

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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